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Straining to overcome the confusion that resulted from its recently issued fair-value proposals, the Financial Accounting Standard Board this morning approved an altered version of its proposed guidance on how to determine whether a financial market is inactive and an asset sale isn’t distressed.

Both conditions are crucial in measuring the fair value of a financial instrument under FASB’s controversial Statement No. 157, Fair Value Measurements. According to the standard, a fair value can’t be applied to an instrument sold in a distressed, or forced, transaction-like when a company has entered bankruptcy. Determining when a market is inactive is crucial, because that would make measurements derived from it less reliable under 157.

Board members have long stressed that financial statement preparers should use judgment in valuing assets in markets where there’s little hard and fast pricing information, and that principles should hold sway over rules. Somehow, however, many users of financials quickly got the impression that in FASB’s new proposed guidance, it was now favoring a more rigid approach to valuation in illiquid markets.

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After a 15-day comment period that began with the speedy issuance of the proposal on March 17, the board acknowledged, in the words of one member, that it was “screwing things up” in the minds of financial statement users-especially in terms of the overall objective of the proposal.

The measure purports to guide asset holders who mark their holdings to market through a two-step process to help them decide “whether a market for a financial asset that historically was active is not active and whether a transaction is not distressed.”

In response to the comment letters, FASB reasserted that the objective of its fair-value measurement standard holds firm even in inactive markets or ones with rapidly declining volume; clarified that judgment needs to be exercised in determining when a market is inactive; required new disclosures of valuation techniques; and delayed the effective date of its guidance for issuers who don’t want to adopt it early.

In its final reporting guidance, which is expected to be out next week, the board will require that the measure will be effective for periods ending after June 15, 2009, with early application permitted for periods ending after March 15, 2009. Retrospective application will not be permitted. In its proposal, the staff had asked that the measure simply be effective for periods ending after March 15, 2009.

Over 300 letters had flooded FASB by the end of the proposal’s comment period yesterday, and many constituents wondered if the board had changed the objective of a fair-value measurement in an inactive market under FAS 157.

Under the standard, holders of financial assets recorded in fair-value must report on how they came up with their values. They must classify the measurements into three levels of assumptions, depending on how “observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it’s based on “observable market data” other than a quoted market price.

In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (sometimes called “fire sales”), fair value can be determined only through “unobservable inputs” and prices that could be based on internal models or estimates.

Some critics of last month’s proposed guidance on how to apply 157 and a companion proposal on other than temporary impairments (OTTI) said that the measures represent a capitulation to bankers’ demands for weaker standards-and some even saw them as a symptom of the weakening of FASB itself.

In a press conference following the meeting, a reporter asked FASB chairman Robert Herz to react to charges by the CFA Institute that the two staff positions indicated a lack of independence on the part of the board. He also asked Herz to answer the institute’s charge that the speed with which FASB came up with the proposals suggests that it was bowing to “special interests” (in this case, presumably, the banks).

The FASB chairman replied that the board had “reached out to 40 major investors in financial institutions” in addition to the CFA for input on the proposed staff positions. Unlike the institute, most of the investors, while calling for additional disclosures of fair-value measurement methods, approved of the direction in which FASB was headed, he contended, noting that that was especially true of the OTTI proposal.

Acknowledging that the two-week comment period was “accelerated and expedited,” Herz went on to say that the board engaged in “full due process” and that FASB probably got more input than it gets on proposals with three-month comment periods.

To accusations of a lack of independence by the board, Herz said, “What I don’t like really is that when you don’t agree with our end outcome you impugn our motives. That’s not fair-or appropriate.”

In letters to the board, some respondents voiced worries that the proposal on inactive markets and distressed transactions “would result in a relaxation of fair value requirements and reduce consistency and comparability in financial statements,” according to a board meeting handout.

In its proposed guidance, FASB’s staff asserted that the original objective of fair-value measurement hadn’t changed, adding that determining fair value in an inactive market “may require the use of significant judgment.”

Nevertheless, some respondents thought the board had switched gears from its requirement under 157 and was now asking for something more precise and less judgment-based. They began questioning whether the goal of fair-value measurement in an inactive market should be gauging fair value in a currently inactive market; determining what the hypothetical fair value would be in an active market; or figuring out the midpoint between the former two calculations.

Board members, asserting that they didn’t mean that reporting entities should rigidly calculate a midpoint, said that they should use a variety of inputs—but mostly their own judgments. In the guidance approved by the board at its meeting today, FASB stated that even when there’s been a significant decrease in market activity for an asset, “the fair-value objective remains the same. Fair value is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date in the current inactive market.”

Earlier, board staffer Adrian Mills, reading from a staff handout, said that gauging fair value “in a market where there has been a significant decrease in the volume and level of activity for the asset at the measurement date is inherently complex, depends on the facts and circumstances and involves significant professional judgment.”

In another move on Wednesday, the board erased the presumption in the staff proposal “that all transactions are distressed unless proven otherwise.” FASB acknowledged that its intention wasn’t to exclude relevant transaction information or preclude the use of pricing services or brokers in a fair-value measurement.

Some respondents had believed that the presumption would have enabled reporting entities to ignore relevant market data. Other respondents were concerned about the unintended consequences that could ensue if reporting entities were “forced to dismiss quoted prices provided by pricing services or to otherwise exclude relevant market data.”

In terms of disclosure, the board will require reporting entities to reveal changes in valuation techniques resulting from the application of the new guidance and to quantify the effects of the changes, if that’s practical.

The new guidance will set up a two-step process for reporting entities to use in gauging when a market is inactive and when a financial transaction is distressed. In step 1, asset holders would assess at least seven factors in gauging whether to pronounce a market inactive. (“Those factors should not be considered all inclusive because other factors may also indicate that a market is not active,” FASB cautions.) The factors are:

-There are few recent transactions in the market.

-Price quotes aren’t based on current information.

-The quotations vary heavily, either over time or among brokers.

-Indexes that in the past were highly linked to the asset’s fair values “are demonstrably uncorrelated with recent fair values.”

-Abnormally big liquidity risk premiums or yields on the assets.

-Abnormally wide bid-ask spreads or big hikes in the spreads.

-Little publicly released information.

After the asset holder does a thorough evaluation using those factors, it must “use its judgment in determining whether the market is active.” If it concludes in step 1 that the market for the asset isn’t active, then it would proceed to step 2.

In step 2, the asset holder must presume that a quoted price stems from a distressed transaction unless the asset holder can prove that there was enough time before the measurement date to allow for normal marketing activities for the asset. There would also have to be many bidders for the asset for the price to be deemed not distressed.